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Dividend Policy in the Absence of Taxes Dividend Policy in the Absence of Taxes Khamis Al-Yahyaee, Toan Pham*, and Terry Walter School of Banking and Finance, University of New South Wales Abstract We examine dividend policy in Oman, this being a unique environment where firms distribute almost 100% of their profits as dividends, and where firms are highly levered through bank loans, thus reducing the role of dividends in agency cost mitigation. We find that profitability, size and business risk are factors that determine dividend policy of both financial and non- financial firms. Government ownership, leverage and age have a significant impact on the dividend policy of non-financial firms but no effect on financial firms. The factors that influence the probability of paying dividends are the same factors that determine the amount of dividends paid for both financial and non-financial firms. Our results also show that agency costs mitigation is not a critical driver of dividend policy of Omani firms. Finally, we apply the Lintner (1956) model and find that non-financial firms adopt policies that smooth dividends, whereas financial firms do not have stable dividend policies. JEL Classification: G35 Keywords: dividends, taxes, agency theory December 2006 * Corresponding author. E-mail address: [email protected]. School of Banking and Finance, University of New South Wales, Sydney, 2052 Australia. Phone: +61 2 9385 5869 Fax: +61 2 9385 6347 1. Introduction “Although a number of theories have been put forward in the literature to explain their pervasive presence, dividends remain one of the thorniest puzzles in corporate finance” (Allen, Bernardo, and Welch (2000, p.2499)) The question of “Why do corporations pay dividends?” has puzzled researchers for many years. Despite the extensive research devoted to solve the dividend puzzle, a complete understanding of the factors that influence dividend policy and the manner in which these factors interact is yet to be established. The fact that a major textbook such as Brealey and Myers (2003) lists dividends as one of the “Ten unresolved problems in finance” reinforces Black’s (1976, p.5) statement “The harder we look at the dividend picture, the more it looks like a puzzle, with pieces that just don’t fit together”. Several rationales for corporate dividend policy are proposed in the literature, but there is little consensus among researchers. On the whole the literature focuses on several strands of hypotheses of dividend policy. The seminal Miller-Modigliani’s irrelevance theory has been tested and largely supported by Black and Scholes (1974), Miller and Scholes (1982), Miller (1986), Conroy et al. (2000) while contrary evidence has been reported by Baker and Farrelly (1988) and Baker et al. (2005). Mixed results are also found for the tax hypothesis (Black and Scholes (1974), Litzenberger and Ramaswamy (1980), Miller and Scholes (1982), Poterba and Summers (1984), Keim (1985), and Kalay and Michaely (2000)). The agency cost based hypothesis argues that dividend payout helps align the interest of managers and shareholders by reducing the free cash flow for use at the discretion of managers (Jensen and Meckling (1976), Rozeff (1982), Easterbrook (1984), Jensen (1986), Jensen et al. (1992), Lang and Litzenberger (1989), DeAngelo, DeAngelo and Stultz (2004)). While the literature is voluminous and is still evolving the results continue to be inconclusive. In this context Oman is a unique case to revisit the dividend issue. In Oman, there are no taxes on dividends or on capital gains. The absence of taxes may provide a ‘clinical’ or uncluttered environment to re-examine the dividend puzzle. There are four main objectives of this paper which are, first, to identify the factors that determine the amount of dividends, second, to examine the decision to pay dividends, third, to outline the potential differences in dividend policy between financial and non-financial firms, and fourth, to apply the Lintner (1956) model to test the stability of dividend policy. 1 There are many important motives for this study. First and foremost, Omani firms distribute almost 100% of their profits in dividends which led the Capital Market Authority to issue a circular (number 12/2003) arguing that firms should retain some of their earnings for “rainy days”. This practice provides an opportunity to examine the characteristics of firms that pay dividends. Second, the study will be conducted in a unique environment where there are no taxes on dividends and capital gains. Tax differentials are a major part of the dividend puzzle. Third, one explanation for paying dividends is to minimize agency problems. However, Omani firms are highly levered through bank loans, which reduce the role of dividends in alleviating agency problem (Al-Yahyaee, Pham, and Walter (2005)).1 Fourth, the determinants of dividend policy are controversial and there is no unanimity among researchers on the factors that affect dividend policy. This controversy motivates this research to provide some new evidence as to the factors that affect dividend policy. Fifth, most previous research excludes non-dividend paying firms which may create a selection bias (Kim and Maddala (1992), Deshmukh (2003), among others). We include non-dividend paying firms in our experimental design. Finally, there are some studies that report differences between dividend policy of financial and non- financial firms (Naceur, Goaied, and Belanes (2005)).2 We examine this issue for Oman. Apart from the fact there has been no study of dividend policy in Oman, this paper contributes additional evidence to contrast the dividend policies in emerging and developed markets. Our research provides a number of interesting results on dividend policy. First, we show that there are common factors that affect the dividend policy of both financial and non-financial firms, and there are others that affect only non-financial firms. For example, there are six determinants of dividend policy for non-financial firms, while there are only three factors that affect the dividend policy of financial firms. The common factors are profitability, size, and business risk. Government ownership, leverage, and age have a strong influence on the dividend policy of non-financial firms but no effect on financial firms. On the other hand, agency costs, tangibility, and growth factors do not appear to have any impact on the dividend policy of both financial and non-financial firms. Second, we find that the determinants of the decision to pay dividends are consistent with those reported for the determinants of dividend policy. In particular, we find that the factors that 1 See Aivazian, Booth, and Cleary (2003a) for a discussion on the role of bank debt in reducing the agency cost. 2 Sawicki (2002) documents that there are significant differences in dividend payout of different industries using a sample of firms from East Asia. 2 influence the probability of paying dividends are the same as those that determine the amount of dividends paid. Third, the empirical results in this paper show that the speed of adjustment differs substantially between financial and non-financial firms. While we find that non-financial firms adopt a policy of smoothing dividends, this is not the case for financial firms. In fact, we find that financial firms do not have stable dividend policies. The remainder of the paper proceeds as follows. Section 2 briefly discusses the potential determinants of dividend policy and develops testable hypothesis. Section 3 describes the data, develops the regression specifications, presents summary statistics for the payment of dividends, and reports some descriptive statistics for the sample. Section 4 presents the results for the determinants of dividend policy. In section 5 we provide the results for the determinants of the likelihood to pay dividends. In section 6 we examine the stability of dividends using the Lintner model. Section 7 concludes the paper. 2. Factors that Influence Dividend Policy Based upon the determinants of corporate dividend policy identified by the previous theoretical and empirical studies and the availability of data in the “Share-Holding Guide of Muscat Securities Market (MSM) Listed Companies”, Omani Securities Market, in this section we describe the factors that are chosen as determinants of dividend policy. 2.1. Profitability Profits have long been regarded as the primary indicator of a firm’s capacity to pay dividends. Since dividends are usually paid from the annual profits, it is logical that profitable firms are able to pay more dividends. To examine whether the profitability of the firm influences its dividend policy, we use the ratio of earnings before interest and taxes to total assets as our surrogate for profitability. We expect to find a positive relationship between dividends and profitability. 2.2. Firm Size Variables such as size have the potential to influence a firm’s dividend policy. Larger firms have an advantageous position in the capital markets to raise external funds and are therefore less dependent on internal funds. Furthermore, larger firms have lower bankruptcy probabilities and therefore should be more likely to pay dividends. This implies an inverse 3 relationship between the size of the firm and its dependence on internal financing. Hence, larger firms are expected to pay more dividends. As a surrogate for firm size, we use the natural logarithm of sales. 2.3. Leverage Leverage may affect a firm’s capacity to pay dividends because firms that finance their business activities through borrowing commit themselves to fixed financial charges that include interest payments and the principal amount. Failure to make these payments by the due time subjects the firm to risk of liquidation and bankruptcy. Higher leverage might thus result in lower dividend payments. Furthermore, some debt covenants have restrictions on dividend distributions. Thus we expect a negative relationship between dividends and leverage. We use the debt ratio as our proxy for leverage. 2.4. Agency Costs The separation of ownership and control results in agency problems.
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